How Overtime Is Taxed and Why It Seems Higher

Overtime pay often represents a welcome boost to an individual’s earnings. However, the taxation of these extra hours can sometimes lead to confusion, with many individuals perceiving that their overtime wages are taxed at a disproportionately higher rate. Understanding how overtime is treated for tax purposes is important for managing personal finances and anticipating annual tax obligations. This knowledge helps clarify why the amounts withheld from overtime pay might appear larger than expected.

Overtime as Regular Taxable Income

Overtime compensation is considered regular income for tax purposes. When an individual earns overtime, these earnings are added to their gross income, which then becomes subject to federal income tax. The federal income tax system operates on a progressive scale, where different portions of total income are taxed at increasing rates. Increased total income from overtime can result in a portion of an individual’s highest earnings falling into a higher marginal tax bracket. This means only the income within that higher bracket is taxed at the elevated rate, not the entire income.

Beyond federal income tax, overtime pay is also subject to Social Security and Medicare taxes, collectively known as FICA taxes. These are flat-rate taxes applied to all earned income, up to an annual wage base limit for Social Security. Unlike income tax, FICA taxes apply uniformly across all wages, including overtime, without a progressive bracket system. Additionally, overtime earnings are subject to applicable state and local income taxes, which vary based on geographic location. These taxes are typically a percentage of gross income or calculated based on state-specific tax brackets.

A recent development, the “No Tax on Overtime” provision, introduces a federal income tax deduction for qualified overtime compensation. This provision, effective from January 1, 2025, through December 31, 2028, allows eligible individuals to deduct up to $12,500 ($25,000 for joint filers) of their overtime pay from their federal taxable income. This deduction applies only to federal income tax, and overtime wages remain fully subject to Social Security and Medicare taxes, as well as any applicable state and local income taxes.

Understanding Overtime Withholding

The common perception that overtime is “taxed more heavily” often stems from the amount withheld from a paycheck, rather than the actual tax liability at the end of the year. Tax withholding refers to the portion of income an employer holds back from each paycheck to cover estimated tax obligations, which is then sent to the Internal Revenue Service (IRS) on the employee’s behalf. This process differs from the actual tax liability, which is the total amount of tax owed based on an individual’s complete annual income and deductions.

For federal income tax purposes, overtime pay is frequently classified as “supplemental wages” by employers. This category includes other payments such as bonuses, commissions, and severance pay. The IRS provides specific methods for employers to calculate federal income tax withholding on supplemental wages. One common approach is the percentage method, also known as the flat rate method. Under this method, a flat 22% rate is applied to supplemental wages up to $1 million within a calendar year.

This flat 22% rate can make it appear as if overtime is taxed more heavily, particularly for individuals whose regular wages place them in a lower federal income tax bracket, such as the 10% or 12% bracket. When a 22% flat rate is applied to a portion of their income, the immediate deduction from their paycheck is noticeably larger than the percentage typically withheld from their regular pay. This higher withholding reflects a simplified withholding calculation designed to ensure sufficient taxes are collected throughout the year.

An alternative method employers can use is the aggregate method. This involves combining the supplemental wages with the employee’s regular wages for a pay period and then calculating withholding as if the total amount were a single payment. The withholding is then determined using the employee’s Form W-4 and the standard IRS withholding tables. While the aggregate method may result in withholding that more closely aligns with an individual’s actual marginal tax rate, it is often more complex for employers to administer compared to the flat rate method.

Impact on Your Annual Tax Liability

All income earned throughout the year, including regular wages and any overtime pay, is aggregated when determining an individual’s annual tax liability. This total income is reported on tax forms like Form W-2, which employers provide at year-end detailing wages and withheld taxes. The final federal income tax owed is calculated based on this aggregated total taxable income, not on individual paychecks or specific types of income.

Increased total income due to overtime can indeed push a portion of an individual’s earnings into a higher marginal tax bracket. For instance, if an individual’s regular pay falls within a lower tax bracket, but significant overtime earnings push their total income past the threshold for the next bracket, only the income falling into that higher bracket will be taxed at the increased rate. The income below that threshold remains taxed at the lower rates.

Deductions and credits play an important role in reducing an individual’s final tax liability. Tax deductions decrease the amount of income subject to tax, while tax credits directly reduce the amount of tax owed. These tax benefits apply to an individual’s overall taxable income, regardless of whether it originated from regular wages or overtime. The recent “No Tax on Overtime” provision, for example, functions as an above-the-line deduction, reducing taxable income for eligible individuals. This deduction can be claimed even if an individual takes the standard deduction, providing a direct reduction in federal income tax liability.

At the end of the tax year, the total amount of tax withheld from all paychecks throughout the year is reconciled against the actual total tax liability calculated on the annual tax return. If the total withholding exceeds the actual tax liability, the individual is due a tax refund. Conversely, if the total liability is greater than the amount withheld, the individual will owe additional taxes. The higher withholding on overtime, particularly through the 22% flat rate method, often results in an overpayment of taxes throughout the year. This overpayment typically translates into a larger tax refund or a smaller amount of tax due when the annual return is filed, effectively balancing out the initial perception of higher taxation on overtime earnings.